dwot (29.71)

Milkmaid Investments

0

... The milkmaid was carrying her milk in a pail on her head, daydreaming about how much butter she can make with the milk. She thinks that when she sells the butter, she can buy a lot of eggs. The eggs will then hatch into chickens. And the chickens will bring even more money, so she can buy a new dress... While daydreaming she tossed her head scornfully, and down fell the pail of milk to the ground. And all the milk flowed out, and with it vanished butter and eggs and chicks and new dress and all the milkmaid’s pride. Never count your chicks before they are hatched...

I am going to do a back of the napkin calculation of the type of loss an investor would have on a $100,000 mortgage that is to be repaid over 30 years. I don't claim to understand what has happened here, and I don't need to understand to have felt utterly ill that banks would have ever considered increasing leverage from 12.5 to 30 and that regulator would have allowed it to happen.

But, I am going to do some calculations on what I think has happened. The mortgages have been repackaged into bonds of sorts and from my understanding of bonds is that they don't sell at face value, but they tend to be priced to market rates. The average rate of these mortgages due for reset isn't the 1 and 2% teaser rates making the news, but 7% and they are resetting to 10 or 11%. I will use 10% for this analysis, but for ease of calculations I will assume after 5 years of interest only it goes to 10% where it has a 25 year amortization to pay it back.

From reading about the various state pool funds I've seen interest rates of somewhere between 5 and 6% so I will assume the mortgage bonds were repriced to give a 5.5% return to investors. The homeowner is paying 7%, but the investor has paid a premium for the bond so they are only getting 5.5%. The scam artist in the middle, aka the financial middle men who are to investors what psycho was to the woman in the shower (and the financial middlemen have about the same level of person ethics and humanity as psycho) have made a killing here.

Now, the homeowner would have borrowed $100k but the investor would have paid a premium for the bond because of repricing the mortgage to pay the investor 5.5% instead of the 7% and 10%. I am going to simplify the math here.

The income stream that the homeowner pays is $7k of interest for the first 5 years, or $35k of interest. When payments are priced at 10% that include reducing the principal the home owner pays about $909/month, or $10,908 for 25 years, or $272,700 plus the $35k for a total of $307,700. Here's where I simplify the math, I just assume 5.5% return over the life of the investment, so what would principal today be to get $307,700 paid out at 5% with a combination of principal and interest?

So, to pay out $307,700, easiest is to assume equal payments for 30 years, or about $855/month.

Omg, omg, omg, be still my heart, looking at this kind of thing amazes me. What I get is if you borrow $151,000 at 5.5% over thirty years with payments of about $855 you will have paid out a total of $307,700.

So, with these assumptions, the homeowner would have borrowed $100k at the various interest rates that reset to 10% after 5 years and the bondholder would have paid $151k for that debt, in order to get an extra what, and extra 1-2% of interest with enormous risk?

It doesn't take much to see here that if that $100k mortgage for the homeowner is $50k underwater and foreclosed on, the investor only gets $50k and seeing how they paid $150k, they lose 2/3rds of their investment.

If the homeowner instead pays 7% for the life, rather than jumping to 10% after the first 5 years they end up paying the $35k for the first five years, but then they paid $8472 per year, for $246,800. That reset reduces life time payments by $61k. They end up paying an average of $686 per month for the next 30 years. If I calculate what $246,800 would be worth at 5.5% you'd get $103k today, so the loss would be around 1/3rd, or alternatively, the rate of return over the 30 year is 3.6%, about 2% less than promised.

Ekkk, this is ugly. I am tired, not sure about the quality of my edit...

What experience and history teach is this -- that people and governments never have learned anything from history, or acted on principles deduced from it - Georg Wilhelm Hegel, 1770 - 1831

With the massive Bush freezes, I think a lot of the restructuring of these loans are going to ameliorated. While this will prevent the raise in interest rate boost, it will dramatically decrease the rate of default and possibily increase estimates for recovery in the event of foreclosure.

Any type of CDO-squared will probably be worthless at this point. However, the super senior cash-CDO's actually haven't had much cash flow impairment at this point. Keeping the notes as 7% notes with only 25% default, is much better than the 11% notes with an estimated 80% default. The investors are going to get hosed, but I imagine that the market has massively overshot the value of these loans.

If you used ABX credit spreads to value Fannie Fae and Freddie Mac, would would have to assume that these companies are insolvent by approximately $1TR. The subprime crisis is not trivial, but the US economy will survive it. I would probably say we are more likely to be close toward the end, than the beginning of the crisis.

Remember that declining housing prices have been a problem since 2005, but we weren't just paying attention when the subprime lenders started blowing out in December. I think a lot of risk has been disclosed at this points, and there is going to be some pain in making for some reserve requirements.

So, who has actually looked at an individual CDO, what's in it and what it was sold for?

My only experience with bonds is with my last investment advisor and I know I paid a very different face value compared to what the rate of return was. I know when I sold one it was priced to give about a 4-5% rate of return but I think it was originally a 7% offering.

This was an interesting, somewhat simplified calculation to do. Certainly to me it demonstrated the degree of leverage you can get on the future income stream when the debt is long term debt.

I came up with 5.5% because of reading about the Florida Fund, which featured the man who worked for the schools who was so pleased to be getting about that rate on their school funds. Actually, I just found an article and were getting 5.77%.